What is a debt-to-income ratio?It’s no secret that managing debt is a central part of financial wellness. In fact, paying down debts is critical for keeping your credit reports clean, maintaining a healthy credit score and building up your savings. But did you know that higher levels of debt can also affect the types of loans and credit cards you qualify for? This is because, for most lenders, the amount of debt you have is nearly as important as whether or not you’re paying it down. That’s where a metric known as the debt-to-income ratio (DtI) comes in. Along with other factors, this ratio is used by some lenders to help them determine who they should extend a loan or credit card to. Continue reading to learn more about the debt-to-income ratio and find out how it relates to your finances.

Debt-to-income ratio defined

It’s obvious that your income directly impacts how much debt you can afford to pay in a given month, so lenders and financial advisors use your debt-to-income ratio to model this relationship. Your debt-to-income ratio is calculated by taking your total monthly debt payments and dividing the sum by your gross monthly income. For example, if you pay $150 each month to existing credit card debt, $2,500 to a mortgage and $350 to an auto loan, you’d add those numbers together ($3,000) and divide that by your gross monthly income (let’s say it’s $6,000) to get a percentage — in this example, it’s 50%. Higher percentages mean that more of your income is going toward servicing your debt, which can imply that you’re financially stretched thin. This can have implications for both your financial health as well as any lender’s willingness to let you borrow from them.

Why does your debt-to-income ratio matter?

Your debt-to-income ratio is not the be-all and end-all when it comes to approval for a loan or credit card, but if you have excellent credit and find your application declined, this could be one of the reasons why. Although the debt-to-income ratio has no bearing on your credit scores or reports, many lenders take it into account when deciding whether or not they’ll issue credit to you. Lenders typically have cutoff percentages determining when a specific debt-to-income ratio can be deemed too high. For example, in order to be eligible for a qualified mortgage, you’ll need to have a debt-to-income ratio of 43% or lower. Still, individuals with higher ratios might qualify for other types of mortgages, which illustrates that there is no universally agreed upon debt-to-income ratio. That’s because debt-to-income ratios are often evaluated based on the type of loan or credit you’re applying for, and different lenders will have different standards based (in part) on your individual financial situation. This means that, in some cases, higher ratios might not impact your eligibility for credit. That said, the lower your debt-to-income ratio is, the better things will be for you given that higher debt-to-income levels come with some degree of financial constraint. One oft-stated rule of thumb that some lenders use is called the 28/36 rule, which states that no more than 28% of your gross income should go to household expenses and no more than 36% should go toward paying down your debts. With this in mind, striving for a debt-to-income ratio of 36% or lower is a good idea, even if it might not be strictly necessary to appease every lender.

Is debt-to-income related to credit utilization?

Lenders talk a lot about debt and financial ratios, and one term you might have come across is the concept of a credit utilization ratio. Although a debt-to-income ratio and a credit utilization ratio sound similar, they aren’t the same thing. Both can impact your eligibility for credit, but the latter focuses on how much debt you have in relation to your total credit limit without consideration for your income. It’s true that both metrics, when combined, give lenders a clearer idea of your financial health. For example, someone with high credit utilization and a high debt-to-income ratio is close to maxing out their credit and has very little disposable income to reverse this trend — something which would worry a lender or anyone else invested in this individual’s financial health. Should this person lose their job or receive a cut in pay, it could very well jeopardize their ability to pay their debts in full.

How can you track and improve your debt-to-income ratio?

Consumers hoping to learn more about their debt-to-income ratio have a number of options available to them. Today, there are tons of online calculators that can help you figure out this ratio and what it might mean for you. Additionally, most modern financial and budgeting programs or apps can track your earnings, spending level and the debts you have, allowing you to create a real-time measure of your debt-to-income ratio every month. Finally, you might choose to do it the old-fashioned way with pen and paper, either as a part of your budget or while working with a financial advisor.

Regardless of how you track your debt-to-income ratio, if your goal is to improve it, here’s how you can do it:

  • Increase your income. This solution is a rather obvious one — more money means more money to pay down debt — though it’s often easier said than done. If you’ve been wanting to look for a new job, it might be the time for you to do that. Those who are already happy with their job can ask their manager for a slight pay increase (remember that you’ll want to explain why you deserve a raise) or even consider picking up a second job as a freelancer or just take on part-time work.
  • Pay down your most affordable debts quickly. This is another obvious but important suggestion, as less debt will lower your debt-to-income ratio. While this might not always be feasible, make sure you examine your debts thoroughly before deciding if it can work. It could be that you have fees or payments that you can afford to pay in full without being financially overstretched, but you have to evaluate your finances to determine if it’s doable. You can also work with a debt counselor or financial planner who might aid you in coming up with a strategy to pay off your debt.
  • Reduce interest on current debt or new debts. Lower interest charges mean that over the life of your borrowing cycle, you’ll pay less. If you’re about to take on more debt, be it via a credit card or loan, make sure you negotiate to get the lowest rates possible. For those currently struggling with their debt, it might also be possible to make an agreement with a lender to reduce the cost of any monthly payments or you may even want to consider a balance transfer credit card, which will help you avoid credit card interest for a long period of time.

While personal finance might be a complex topic, understanding it doesn’t have to be difficult. Keep reading our personal finance blog to learn the terms and tips you need to successfully manage your finances.